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Microsoft Corporation (MSFT)

Founded in 1975, Microsoft (MSFT) is most famous for its Windows operating system, which runs approximately 87% of the world’s computers.

However, in recent decades the company has vastly diversified its operations to become a software and hardware powerhouse that operates three distinct business segments:

  • Productivity and Business Processes (31% of sales, growing 25% a year): Office 365 commercial and consumer product suites, which include Office, Exchange, Outlook.com, Skype, and OneDrive cloud solutions for businesses and individuals.

  • Intelligent Cloud Services (27% of sales, growing 15% a year): server and cloud-based solutions, including its fast-growing Azure business cloud platform.

  • More Personal Computing (42% of sales, growing 2% a year): traditional Windows business on PCs, as well as its Xbox gaming platform and Bing search engine.

While personal computing remains the largest revenue driver, these legacy businesses are by far the slowest growing. Microsoft's fastest-growing and most profitable businesses are focused on cloud computing as well as subscription-based Office and enterprise products. 

Business Analysis

Microsoft became an industry giant on the back of its Windows operating system (OS) and the rise of personal computers (PCs) in the 1990's. However, under former CEO Steve Ballmer, the company's ill-conceived notion of "Windows and PC first" led to years of stagnant growth.

PC demand slowed, driven by the rise of mobile devices, and rivals in both consumer (open source software and Google Docs) and enterprise (Linux-based enterprise solutions) markets began to erode its wide moat. 

In 2014, Satya Nadella, a 20-year veteran of the company and head of its cloud computing division, took over as CEO with a "cloud and mobile first" vision to pivot the company into the fast-growing industries of tomorrow. 

It hasn't been a perfect transition, as the failure of Windows 8 and the abandonment of the Windows Phone mobile operating system demonstrated. However, as a whole, Nadella's strategy of shifting Microsoft away from its traditional reliance on PC-installed Windows and enterprise server solutions has been a triumph. 

The company is now laser-focused on subscription services, including Office 365 enterprise, Office 365 consumer, and Dynamics 365 (enterprise level deep data analytics), all built around its Azure cloud computing platform. 

In essence, Microsoft is no longer stubbornly clinging to its high margin but declining past, but focused on a fast-growing future filled with recurring, annuity-like revenue that offers even higher margins to boot. 

Microsoft's success can be seen by the steady growth recently recorded across its most important offerings, including: 

  • Office 365 enterprise: 30% subscriber growth
  • Office 365 consumer: 17% subscriber growth
  • Dynamics 365 revenue: 68% growth
  • Commercial cloud revenue: 56% growth
  • Azure revenue: 98% growth
  • Overall company revenue: 12% growth
  • Overall earnings: 20% growth
  • Overall free cash flow: 23% growth

In fact, thanks to the success of Azure, Microsoft is the world's second largest cloud computing company, trailing only Amazon Web Services (AWS). More importantly though, at about 100% annual growth the last two years, Microsoft's cloud business is gaining market share from Amazon, whose cloud service is growing closer to 40% a year.

Analyst firm Gartner expects Amazon and Microsoft to collectively own 90% of the cloud computing market by 2020. And that market, or specifically the areas that Microsoft is targeting, is projected be growing at 15% to 23% a year at that time.

In other words, Microsoft is now well positioned to become a duopolist in one of the largest, fastest-growing, and most important industries in tech. To help it maintain its lead and fend off numerous hungry competitors (more on this in a moment), the company has been working diligently to make sure it continues to upgrade and improve its offerings. 

In other words, Microsoft doesn't just want to be a king of the cloud, it wants to build an entire ecosystem that creates high switching costs once it has won a customer's recurring subscription business. 

For example, Microsoft has made sure to make its Office 365 suite far more feature rich than Alphabet's competing Google Docs. Owing to its free nature, Google docs used to be the largest online document platform, but today Office 365 consumer has taken the crown. 

Meanwhile, in enterprise the company has been heavily focused on converting its dominant position in offices around the globe (over 1 billion users) into deeply integrated subscription-based offerings that help companies of all sizes meet almost any need. That includes everything from outsourcing their website and data storage needs, to organizing their accounting, payrolls, and various HR needs. 

In other words, Microsoft is becoming a one-stop shop for all of its corporate customers' needs. More importantly, unlike in the past, Microsoft isn't trying to necessarily wall itself off. That means rather than obsessively try to control all of its applications, Microsoft has adopted a platform-neutral approach to app development. 

For example, Azure (its business cloud platform) now supports various software platforms, including not only its own Windows, but also competing Linux, as well as open source. This has allowed Microsoft's app ecosystem to balloon into the millions as it effectively crowdsources great ideas from developers all over the world, who are designing, testing, and perfecting their applications on Microsoft's Azure platform while paying the company for the privilege. 

Best of all, because all of this is software based, it's not overly capital intensive, so Microsoft's profitability has been steadily improving with operating margins approaching 30%. Going forward, analysts expect Microsoft's profitability to improve further on the back of Azure (30% long-term growth), which will ultimately make up around 40% of its business and help push its operating margins towards 40%. 

That should mean that Microsoft's free cash flow (what ultimately funds the dividend) will continue to grow strongly, likely helping fuel impressive 10+% dividend growth as well. 

Overall, Microsoft has made a very impressive turnaround, thanks to the strong leadership of its new cloud and subscription-focused CEO. The company has already taken a major chunk of the large and fast-growing cloud computing market while seamlessly integrating subscription versions of its legacy software into very lucrative, recurring, and cash-rich businesses. 

This bodes well for its long-term dividend growth prospects and potentially makes Microsoft a solid choice for a diversified dividend growth portfolio. 

However, that doesn't mean that Microsoft doesn't still have challenges ahead that investors should be aware of before considering buying the company's shares. 

Key Risks

While Microsoft has become a resurgent giant in the last few years, there are still a few risks to keep in mind. 

First, the company's legacy Windows operating system and Windows Server businesses are likely in long-term decline and will drag on sales growth and margins for the foreseeable future. This is because PC growth is expected to decline by about 2% a year as consumers increasingly embrace PC alternatives such as Chromebooks, tablets, and smartphones. 

Fortunately, the company is doing well at transitioning its existing and enormous user base to its cloud subscription model, both on a consumer and enterprise level. Which basically means that as long as Microsoft can continue on its current path, its future looks brighter than ever. 

However, whether or not the company can continue executing masterfully on its cloud first, mobile first approach is not guaranteed. That's because cloud computing is a red hot and booming sector that has attracted numerous enormous and well-capitalized rivals, including: 

  • Amazon
  • Alphabet (GOOG)
  • IBM (IBM)
  • Oracle (ORCL)
  • Saleforce.com (CRM)

Each of these giants is investing large sums of money to help companies with data analysis and business optimization. Microsoft is also investing heavily into artificial intelligence but seems to be slightly behind industry leader Alphabet.

Alphabet has not one but two subsidiaries focused on winning the race to teach software to think on its own (and improve itself), courtesy of the world's largest data stream compiled from its entrenched online user base. Its goal is to create a superior offering to Azure and AWS that will underpin Google's own cloud offerings (current market share 6%). Urs Holzle, head of Google Cloud, even wants cloud service revenue to overtake advertising by the end of 2020.

Whether or not that actually happens, the point is that Microsoft can't rest on its laurels as it did in the Ballmer days. The competition in cloud is fierce because the prize is literally becoming a cornerstone for the future of technology, and thus the entire global economy.

Finally, we can't forget that as Microsoft achieves ever-greater success and its cash position rises, there is a growing risk that the company might repeat its history of terrible acquisitions.

For example, Steve Ballmer was famous for ill-conceived deals designed to restart Microsoft's growth engines, including the $9.5 billion acquisition of phone maker Nokia. That total failure resulted in a $7.6 billion write-down when Nadella wisely decided to abandon Windows Phone mobile operating system.

However, Nadella, despite being focused on cloud and mobile applications, isn't above potentially grandiose acquisitions, including paying $26.2 billion for LinkedIn in 2016.

The rationale behind this purchase was that LinkedIn's leading market position as the world's top professional social networks could be smoothly integrated into Microsoft's Azure-based cloud offerings and thus make its top priority businesses even more competitive.

So far it appears as if the plan is working, as Azure and commercial cloud businesses continue to grow like weeds. However, note that while LinkedIn sales are also growing strongly (about 20% a year), the company is still generating accelerating losses for Microsoft.
Source: Microsoft Earnings Presentation

Thus it's uncertain whether or not this purchase will ever become accretive to earnings. However, the good news is that Nadella's approach to M&A does appear far more disciplined than Ballmer's. 

Specifically, he is going after companies that have a strong direct link to Microsoft's cloud and subscription-focused future, and thus are less likely to become complete write-offs in the future. 

Closing Thoughts on Microsoft

Microsoft has come a long way from the moribund growth years under Steve Ballmer. Current CEO Satya Nadella's strong focus on cloud computing and subscription services incorporated into Microsoft's sticky ecosystem has once again returned the company to strong double-digit sales, earnings, and free cash flow growth. 

While it's still too early to judge some capital allocation moves, such as the $26 billion acquisition of LinkedIn, it's clear that Microsoft is once again a leading global technology company with an apparently expanding lead in the most important growth markets of the future. 

More importantly, Microsoft is once more a company with the strong pricing power and large free cash flow generation needed to make it one of the best blue chip dividend growth stocks in tech. 

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